Prepare for Lift-Off at Rolls-Royce

By Robert Sutherland Smith 

Rolls-Royce (RR.) needs no introduction. It is a paragon of economic virtue; a model of what British Industry more characteristically used to be; a company that is at the cutting edge of technology in which it is a global leader. It employs 55,000 people worldwide, of which 17,000 are engineers of and 288 apprentices.

None of which necessarily means that the shares are a ‘buy’, mind you.

Such a share does get dear and overbought from time to time. In periods of market uncertainty it looks the safest bet in the market – and that can mean the shares getting overbought. That was the situation for most of 2013, when you can see that the shares went well above the long term trend. By 2014 the market was ripe for the bearish news to justify sale recommendation by brokers. The market found that in some areas of its business – like the energy sector, military hardware and embargoed Russia – all was not well.

However, these problems are marginal relative to the long term flourishing businesses it operates, including civil aviation, where demand is strong. At this juncture, I point out that Rolls-Royce is a company with a long term order book which, at £70 billion, equates to 4.5 times last year’s annual sales revenue of £15.5 billion. Thus it benefits from a solid core of long term future work and work in progress, which rather puts its problems, such as they are, into perspective.   

The ‘technical’ position of the shares also looks encouraging. The share price reached a bottom of 777p last October, and has since bounced nicely to 902p last seen. In doing so, they have arguably broken out of a downtrend. Check the chart for yourselves; chart reading is a personal exercise. Suffice to say, it looks to me like a break out. I might add that I have been positive on the situation since the shares were priced at 870p in November last year.   

The results for the year to December 2014 look pretty much in line with market expectations. That is to say, orders up 3% to a record £73.7 billion, underlying revenue down 5%, and underlying pre-tax profits down 4%. Next year, according to guidance from the company, looks likely to be another challenging year in which most areas of operation will remain the same or down a little. Initially, this suggests that the share price may retrace its steps to provide a better long term buying opportunity. 

The current consensus of market estimates for Rolls-Royce include the fact that the company sold it energy engineering business to the German company Siemens in December last year. Partly in consequence of that, the market consensus estimates that earnings may fall 4% in the year just ended to 31st December 2014 to 63.3p. Looking ahead, to the year just begun, consensus forecasts are for a further 3% drop to 61p, followed by a 9% recovery to 66.75p in 2016. At 902p, this puts the shares on estimated prospective price to earnings multiples of 14.4, 14.9 (for this year) and 13.3 for 2016. 

The respective accompanying forecast annual dividend yields are an estimated 2.1% 2.6% and 2.86% for next year. Remember that these are very well covered by earnings to the tune of 2.6 times on the current year estimates. Put another way, the estimated earnings yield for last year is 7%, which I think very attractive. The aforementioned multiples are also good value in my opinion in relation to the quality of the business. Any short term disappointment after the results should translate into a longer term buying opportunity.